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Quantifying the chance of a ‘Grexit’

11-05-2015
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UK | Insight
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Lukas Daalder
The prospect of Greece leaving the Eurozone may not be that bad for investors, and may even be positive in the long run, says Robeco’s head of asset allocation.

Speed read:

Risky assets would be unsettled by a Grexit in the short term

Longer-term ‘Domino Effect’ scenario would also be negative

A ‘Closing of Ranks’ outcome however would be very positive

Chance of a Grexit now put at 30% but debt deal is more likely

New research by Lukas Daalder has attempted to quantify the outcome of a ‘Grexit’ over the short and long term on the main asset classes of equities, government bonds, credits and the euro itself.

He says a Grexit would initially result in short-term chaos, and probably followed by longer-term negativity if there is a ‘Domino Effect’ and the malaise spreads. However, it is also possible that the longer-term outcome could be positive due to a ‘Closing of the Ranks’ by the remaining Eurozone members having ended the Greek debacle once and for all.

The Grexit saga has re-arisen because negotiations with creditors including the European Central Bank (ECB) and the International Monetary Fund (IMF) have stalled. Greece repaid EUR 800 million to the IMF on May 11, avoiding a default which could have led to the ECB pulling the rug on future survival funding. This in turn could have led to Greece either leaving the Eurozone voluntarily, or being kicked out.

Punching ball bounces back
“Another year, another Grexit fear. It is like the punching ball that continues to bounce back no matter how hard you think you have hit it to the other side,” says Daalder, Chief Investment Officer of Robeco Investment Solutions.

“As the situation now stands, we feel that the odds for a Grexit has never been higher, at about 30%, while we expect a 70% chance of some sort of a kick-the-can-down-the-road deal. But what if the negative scenario of a Grexit does take place … what would the impact be on financial markets?”

He says in the short term, European equities would fall, and bank stocks would be particularly vulnerable. He foresees a ‘flight to quality’ into German government bonds, which are still seen as a safe haven, despite their ultra-low yields. Credit spreads – the difference between the yield on corporate bonds and those of benchmark German bunds – would rise, signifying greater risk.

“In the short run, a Grexit would be a negative for risky assets,” he says. “Uncertainty on potential spillovers would drive equities lower and credit spreads higher. There would be a spillover to the peripheral countries, but with the QE program in place, and with the ECB likely to repeat its ‘whatever it takes’ statement in some form or other, there is a clear cap on how far spreads could widen. The euro would stand to suffer though, as a Grexit would place doubt on the strength and solidity of the currency moving forward.”

The ‘Domino Effect’
Daalder says the longer-term impact is much less clear cut and would depend on how the Grexit is seen 18 months after the event. He identifies two scenarios - a ‘Domino effect’ in which other pieces start to fall, or a more positive ‘Closing of the Ranks’.

Under the first scenario, stocks would continue to fall, credit spreads would rise significantly, there would be more safe haven flows in government bonds, and the euro would fall, with its eventual demise being priced in.

“Longer-term, a Grexit could be viewed as the breaking point for the cohesion of the Eurozone,” he says. “The euro could be seen as just another currency peg, just like the Gold Standard back in the 1930s: a system which is optional, but not mandatory. Here, a Grexit shows that the system is susceptible to domestic political developments, and any election win by an anti-euro party, such as UKIP in Britain, is certain to trigger more exit speculations. It is because of this that we attach a 60% likelihood to this more negative outcome.”

‘Closing of the Ranks’
However, a longer-term positive outcome is still possible if the rest of the EU shows enough solidarity and ring-fence what would be a massively weakened Greece, says Daalder.

“Here, the Eurozone is better off after throwing the Greek ballast overboard, leading to a strengthening of the union,” says Daalder. “Greece is faced with a continued depression, high inflation, systemic unemployment and capital controls, which acts as a horrific example of what leaving the euro entails, leading to a closing of the ranks of the remaining members.”

“On balance with this, the impact on financial markets would be minimal, although there may be a small net positive related to the lower euro compared to a situation in which Greece remains in the Eurozone. We attach a 40% likelihood to this scenario.”

In the meantime, Daalder expects some sort of deal to be struck between Greece and its creditors, as this is better for everyone. “We expect both parties will see the benefits of reaching a deal, but with the pressure that is currently built up in the system, things could take a wrong turn,” he says. “Time will tell, but the Grexit story isn’t going to go away anytime soon.”

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